I like the pace of technology, both in finance and in health care, which I occasionally stray into. I have written for Securities Industry News, Risk, Institutional Investor and Alpha. For ten years I edited Windows in Financial Services, covering Microsoft technology in finance, and I continue to write for Banking Technology and Trading Places, both in London.

High Frequency Traders And Current Market Structures Penalize Investors

Pragma, an expert in trade execution, has just published a study show how high-frequent trading (HFT) profits come at the expense of ordinary investors.

“While high-frequency market making is a legitimate activity, the combination of the maker/taker system of exchange fees and rebates and the penny tick size distorts the market and effectively forces investors to subsidize the activity of HFTs,” according to its report, “HFT and the Hidden Cost of Deep Liquidity.”

David Mechner, CEO of Pragma Securities, said this study is significant because it is the first quantitative research to show how HFT profits may come at the expense of investors.

‘It is really notable because most of the real research, the quant research as opposed to people just saying what they think, has said HFT improved market quality. Half a dozen studies in the last two years have shown that spreads have narrowed,” said Mechner.

In their role as market makers, HFT firms make an important role to a healthy market, but certain distortions in the market structure make the profits outsized relevant to the benefits, especially in the liquid end of the market, he said.

Unlike some academic studies which deal only with publicly available information, Pragma used a private data set from its customers, who represent about two percent of total market volume on a daily basis, which showed who was placing the orders.

HFT operates at speeds incomprehensible to most market participants, Pragma noted, and that generates a lot of suspicion.

“HFTs have been blamed for volatility, accused of causing the flash-crash, even of being able to manipulate the entire market for their own benefit. The reality is far less dramatic. Most high-frequency trading is fundamentally a form of market making with very tight inventory control and very short-lived positions.”

Academic researchers are correct they HFT provides valuable liquidity. However, “it is hard to see how they can simultaneously be saving investors money and pulling billions out of the markets in trading profits.”

Pragma’s research came to a counter-intuitive conclusion. Contrary to what most people think, the highest volume stocks the BACs and the MSFTs of the world, are actually costlier to trade than their lower volume peers, Pragma’s study said.

“Although competition among market-makers narrows spreads, the research note shows that reduction in spread is more than offset by the fact that market participants are effectively forced to trade through unwanted intermediaries, resulting in inferior execution prices.”

In competing to earn spreads and rebates by providing liquidity, HFTs crowd out directional traders’ passive orders, force them to cross the spread more often, and result in higher trading costs for investors.

Market makers compete en masse where there is already deep liquidity and no opportunity for price improvement because of the tick size, the Pragma report concluded. From a market structure perspective, the concern is that there is no practical way to opt out of interacting with these superfluous market makers, and because of the take fees charged by exchanges, directional traders are effectively forced to subsidize HFTs even though there are other directional traders they could interact with directly.

By eliminating or limiting rebates for providing liquidity, and reducing the tick size in low- priced stocks above $1 to $0.001, regulators could allow the market to settle on more reasonable spreads in liquid low-priced stocks, and reduce the investor-financed subsidy to HFT market makers and the technology industry that supports them.

Mechner said that the issues we focused on in the paper were:

1 Reform the maker-taker model which creates distortion and conflicts of interest.

2 Reduce the tick size at least for liquid stock so the spread can collapse to a reasonable market level rather than being held artificially wide.”

He is cautious in his claims for potential effect of these changes.

“I don’t know that is a complete solution to all the troubles in the market, but this would provide significant benefits to investors and improve market structures,” explained Mechner. “It would allow investors to give up less to HF traders.”

He expects some change, even without regulatory intervention, such as consolidation of venues, in part because low trading volumes are hurting profitability.

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2) Is this kind of like a grocery store putting up their prices, and then running sales at above their old prices? (I’m looking for a plain English sort of translation/explanation of the remark, “it is hard to see how they can simultaneously be saving investors money and pulling billions out of the markets in trading profits.”.)

3) Who are these people who do “real research / quant research” that have said HFT has “improved market quality”? (ie: are these studies done by independent entities not making any profits off HFT? Or are these studies done by people making a profit off HFT, directly or indirectly, and therefore it wasn’t “real research” at all, but maybe conflict-of-interest skewed data interpretation?)

See the BIS Foresight report as an example of reports that conclude that HFT is good for the markets.

http://www.bis.gov.uk/foresight/our-work/projects/current-projects/computer-trading For a broader look at trading and the larger economy, see the Kay report for the UK government https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/31685/12-631-kay-review-of-equity-markets-interim-report.pdf

See also the Chicago Fed Letter of October 2012 which found weak controls at HFT firms.

Thanks for the links. Of note I think is that the U.K. has a financial transaction tax that covers HFT, correct? Many other countries do. I’m confused about why we in the U.S. don’t. Seems to me a lot of the dispute & suspicion on this topic would go away if we did.

Other value could be other business they get from those customers. HFT advocates say they bring liquidity to the market and narrow spreads. The Pragma study shows that with some stocks and some exchanges which pay traders for liquidity, HFT takes money from investors. Lots of studies exist on this topic, but as you suspect many are funded by the industry. Pragma says the billions in HFT profits come from investors. I will be writing more about this in the future. The Kay report in the UK takes a strong stance in favor of less trading.

What the future holds for hedge funds, HFT and derivatives trading in this age of increased regulatory scrutiny? Discuss it with key players at Tech2Trade Expo 2013, to be kicked off this July 30 in New York City: http://www.tech2tradeexpo.com